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Review of Quantitative Finance and Accounting

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01-01-2015 | Original Research

Evaluation of conducting capital structure arbitrage using the multi-period extended Geske–Johnson model

Authors: Hann-Shing Ju, Ren-Raw Chen, Shih-Kuo Yeh, Tung-Hsiao Yang

Published in: Review of Quantitative Finance and Accounting | Issue 1/2015

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Abstract

This study utilizes a multi-period structural model developed by Chen and Yeh (Pricing credit default swaps with the extended Geske–Johnson Model. Working paper, 2006), which extends the Geske and Johnson (J Financ Quant Anal 19:231–232, 1984) compound option model to evaluate the performance of capital structure arbitrage. In the paper, first of all, we predict the default probability for each firm using the multi-period Geske–Johnson model that assumes endogenous default barriers. Second, based on the arbitrage performance of 369 North American obligators from 2004 to 2008, we find that the extended Geske–Johnson model is more suitable than the CreditGrades model for exploiting the mispricing between equity prices and credit default swap spreads. Finally, the Geske–Johnson model also performs well in extreme market condition, such as the financial crisis around 2008.

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See, for example, Duffie (1999), Longstaff et al. (2005) Hull et al. (2004), Houweling and Vorst (2005) and Blanco et al. (2005).

The model in Chen and Yeh (2006) is based on the original work of Chen (2013) Credit risk modeling: a general framework.

Chen and Panjer (2009) utilize jump-diffusion firm-value process and the observed credit spread to obtain the implied jump distribution. Doing so, they can remove the discrepancy in credit spreads between the structural model and the reduced-form model.

The formulas provided by Geske (1977) are incorrect and corrected by Geske and Johnson (1984). However, Geske and Johnson only presented formulas for n = 2. Here, we generalize their formulas to an arbitrary n. In addition, Eldomiaty and Ismail (2008) find that long-term and short-term debt financing play important role in determining firm’s capital structure.

High grade bonds contain more interest rate risk than credit risk.

Chen et al. (2009) find that the Constant-Elasticity-of-Variance option pricing model could be a better candidate for pricing more complicated path-dependent options or credit risk models.

Guedes and Opler (1996) find that speculative-grade firms typically borrow in the middle of the maturity spectrum, which is consistent with the theory that risky firms do not issue short-term debt in order to avoid inefficient liquidation. In addition, Rauh and Sufi (2010) show that firms that are downgraded from investment grade to speculative grade simultaneously increase their usage of both subordinated bonds and secured bank debt in the 2 years after a downgrade.

This is consistent with Yu (2006) and Currie and Morris (2002). Yu (2006) found that individual correlations ranged from −5 to −15 % according to different data sample periods, indicating that capital structure arbitrage may be ineffective because of a weak correlation between the two markets.

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Title: Evaluation of conducting capital structure arbitrage using the multi-period extended Geske–Johnson model
Authors: Hann-Shing Ju
Ren-Raw Chen
Shih-Kuo Yeh
Tung-Hsiao Yang
Publication date: 01-01-2015
Publisher: Springer US
Published in: Review of Quantitative Finance and Accounting / Issue 1/2015
Print ISSN: 0924-865X
Electronic ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-013-0400-x

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